Individual Retirement Accounts are tax-deferred plans that a participant establishes with a bank, mutual fund, or brokerage; periodic contributions can be invested in different types of securities such as stocks, bonds, etc. The preferential tax treatment applies to all dividends, interest, and capital gains until the age of retirement, which is 59 1/2.
Annual contributions are tax-deductible if certain IRS requirements are met. A participant can only contribute to an IRA if there is no 401(k) plan or other employer-sponsored retirement plan. Contributions are dependent on a participant’s annual gross income (AGI), but in general, there is a limit of $3,000 a year for single participants and $6,000 for married couples. Single participants will be eligible for the deduction if they earned less than $50,000 and married participants will be eligible if their joint income was less than $70,000. Contributions can be made for a particular year until April 15 of the following year.
If the money is taken out before the retirement age of 59 1/2, there is a penalty of 10% in addition to the applicable ordinary income taxes. There are some exceptions to this rule; purchase of a first home up to $10,000, certain higher education expenses, medical expenses above 7.5% of the participant’s AGI, health insurance premiums during unemployment, or permanent disability. A participant is able to roll over a distribution to another IRA or withdraw funds using a special schedule of early payments made over the participant’s life expectancy. Distributions are required to start once the participant reaches age 70 1/2.
In the case of married couples, a surviving spouse can take over the deceased spouse’s IRA and continue the tax deferral. All other beneficiaries have to take the distributions from an Inherited IRA, distributions which are subject to taxation. There are a couple of options on the distributions:
- Lump Sum: Following the five-year rule, a beneficiary may take the amount in the IRA without penalty no later than December 31 of the fifth year after the IRA owner died. The beneficiary can keep what is left of the money after paying ordinary income taxes.
- Little-by-little: IRA distributions paid over the beneficiary’s life expectancy; the annual distributions are subject to taxation. This option must be selected no later than December 31 of the year following the IRA owner’s death. If the money is not withdrawn then the five-year rule will apply.